Adding banker pay into the business of credit ratings is a guaranteed source of easy headlines. Critics of existing financial services pay schemes can argue that the so-called bonus culture does indeed make banks riskier, as agreed by the financial sector itself. It isn’t a criticism from faceless eurocrats who have never got their hands dirty in finance; it is a comment from one of the chief corporate accomplices to the securitization of subprime mortgages and CDOs of ABS.
But Moody’s has performed an about-face since then. Now the agency has implicitly accepted the argument of the European Commission on pay — large compensation packages make banks more risky.
It actually goes further than the Commission, and argues that recent changes to pay structures, including longer vesting periods and more compensation paid in shares, are still risky for bondholders. New, longer timelines are “too short to cover credit cycles and potential tail risks”, while “shareholders’ greater influence over pay practices in recent years could have credit negative consequences”.
It could be said that nobody blew up a bank because they got paid in cash up front and could destroy their institutions without hurting their personal net worth. However, the industry may have pretty much lost this part of the argument, but it is worth repeating.
Dick Fuld walked away from Lehman Brothers a rich man by any standard, but still had 10.8m shares in the firm when it went down. Fred Goodwin really did believe buying ABN Amro was a good idea, and despite his lavish pension, would presumably have preferred to continue making far more money as RBS chief executive and avoid public disgrace. It is easier to blame individual greed than a system which nearly everyone, inside and out, viewed as a money-making machine.
Longer compensation timelines — long enough to cover whatever tail risks Moody’s deems necessary — don’t really address this. No bank employee is consciously putting on a trade which might blow up the bank on a five year time horizon, but not a three year horizon (to give them time to get out after their comp vests). No bank employee should be putting on trades which could blow up the bank at all.
Moody’s also takes issue with pay structures that align executive comp with shareholders. This, the agency says, is a negative for bondholders. If that is the case though, it is a feature, not a bug.
The shareholders own the bank; bondholders provide them with leverage. The owners, it is fair to expect, might want executive interests aligned with theirs, and design compensation schemes to work that way.
Beyond the basic need to keep the institution running, shareholders and bondholders do have opposed interests. More security for bondholders means fewer unencumbered assets; higher interest payments mean less cash flow to equity. A fair point, but hard to see why Moody’s singles out finance.
Rather than focus on when banks pay and what they pay — how long the vesting period is, whether jurisdictions can claw back pay, whether pay is in stock or cash or best of all, structured credit derivatives or Cocos, Moody’s would do better to look at how banks decide pay.
Here, real improvements were needed, and some have already been made (or at least, banks are now keen to trumpet their increased sophistication on such points).
Trading and structuring desks have become far tougher on recognising revenue. If a trade is expected to pay off $10m over 10 years, it’s no longer good enough to run it through net present value and book it all up front. Investment banking divisions are counting up coverage costs as well as execution fees.
Revenue still matters, but person time, capital deployment, and funding costs all matter too. P&L, at least at forward thinking institutions, actually means profit and loss, not revenues accumulated.
These sorts of changes are far more important to building a safer financial system than whether pay comes in year one, year three or year five, and whether it comes in equity or cash.
One might reasonably ask why this has taken so long (and how far it still has to run), but it is a far more important debate than timing and format. Bank employees do respond to incentives — Moody’s just needs to be smarter about what sort of incentives.